What is Leverage and Margin in a Trading Account

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Trading is done on margin and a trading account is using leverage. This is the only way for retail traders to have access to the interbank market liquidity.

Leveraged products are risky products and this is the reason why every broker has a risk disclaimer. As a rule of thumb, the bigger the leverage, the bigger the risk in a trading account.

Leverage shows how much money is being sold or bought in the market. If for example, a trading account has a 1:400 leverage level, it means that for every dollar/pound/euro (depending on the funding currency), four-hundred can be moved.

More exactly, if a trading account using the leverage mentioned in the previous paragraph is funded with 5000 USD, for example, the buying or selling power is 5000 times 400. That shows the actual amount that can be traded in the Forex market.

Balancing a Trading Account

Trading should be done keeping in mind the risks involved but also the potential opportunities. Tremendous amounts of money can be gained, but also lost.

For that caution is needed and a sound money management plan. Any money management plan starts from the leverage in the trading account and the margin involved in any given trade.

What is Normal Leverage?

As mentioned earlier, the smaller the leverage, the safer, so lower leverage is desired. There are Forex brokers that offer even a 1:1000 and more in a trading account, but that is not considered to be a normal leverage level.

1:100 or 1:200 is desired as it combines the opportunities offered in a leveraged account with a normal risk level. Keep in mind that managing risk in a trading account is as important as the trading decision itself.

What is Margin?

For every trade that is opened, a specific margin is being blocked. If you want, this is some kind of a collateral for a respective trade and it is different from currency pair to currency pair.

The balance in a trading account shows the amount funded plus the outcome of any closed trades. If the trades were winning ones, the balance will increase, while it will decrease if the trades were losing ones.

The image above shows the three pillars of a trading account: the balance, equity and the free margin. This account is denominated in U.S. dollars and has no open positions.

We can tell that by the fact that the amounts in all three categories are equal. When opening a new trade, a margin is blocked for that transaction.

At that moment, the free margin amount will decrease with the margin blocked AND with the result of the trade. All the time the trade is open, the free margin in the account will fluctuate.

If the trade goes in the desired direction, or a profit is made, this is going to be seen both in the equity and the free margin fields. The balance will change only after the trade is closed.

The more trades are open at the same time, the smaller the available margin becomes. If the market turns and trades are going into negative territory, the free margin becomes even smaller until it will shrink below 100%.

Such a margin level will trigger an email to the trader’s account, warning that positions are in danger and that the broker will act. This is a margin call!

Margin Call

A margin call is something traders want to never experience. Unfortunately, it is part of the trading education process and during a trader’s formation, it is inevitable.

When opening a trading account, chances are that the first deposit will be lost in a fast fashion. Statistics show that over ninety percent of retail traders are doing that, and chances are that they all experience a margin call during this process.

During a margin call, the trader has two possibilities: either to add funds to the trading account or to close some or all the open positions. Both are difficult decisions to be made.

In the first instance, adding funds is a lengthy process. Nowadays all brokers offer various ways to fund an account and credit cards are accepted, as well as other electronic payment methods.

However, when a margin call is received, things are going from bad to worse. The market moves aggressively and there is no time to waste.

Sometimes, until being able to add new funds to the trading account, the positions will automatically be closed by the broker. If the trader closes some of the open positions, the initial margin (the one blocked as a collateral now the trade was open) is freed and becomes available.

The margin level will increase and, if enough, the new margin will save the account from depletion. However, this is rarely the case.

The biggest hiccup in a margin call is the psychological impact on the trader. Realizing that the money is gone (most of it), can be devastating.

Firstly, losing money has such an effect on people. Secondly, realizing that the trading decision was wrong has even more negative effects and undermines the trust to trade further.

After losing a trading account, to come back and trade requires ambition and desire to succeed. Usually, this is happening after further research about trading and after a strategy and a plan is in place.

Managing risk is everything in trading. One can be the best technical analyst of them all, to know the direction of a market or financial product, and still, lose money if the risk is not managed in a proper way.

To give you an example, if the analysis is made on a daily chart, then the time perspective or horizon of a trade is stretching over several days. In other words, it may be that for several days the market to go against the open positions, but in the end to recover and go in the right direction.

If there is no margin available to sustain this drawdown, a margin call will be received. There is nothing more devastating than to get a margin call and then seeing the market recover and going in the right direction.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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